Journal of Financial Stability 16 (2015) 213–231
Contents lists available at ScienceDirect
Journal of Financial Stability
journal homepage: www.elsevier.com/locate/jfstabil
Catharsis—The real effects of bank insolvency and resolution
Josef Korte ∗
Goethe University Frankfurt, Germany
a r t i c l e
i n f o
Article history:
Received 14 May 2013
Received in revised form 14 March 2014
Accepted 8 May 2014
Available online 22 May 2014
JEL classification:
G21
G28
G33
Keywords:
Bank insolvency
Bank resolution
Bank closure
Bank regulation
Finance and growth
a b s t r a c t
This paper analyzes the impact of rules-based bank insolvency resolution on real economic growth.
Resolving insolvent banks can positively affect the real economy by overcoming moral hazard problems and improving banks’ credit allocation and monitoring. We propose a new indicator to measure the
strength of ‘catharsis’, i.e., how strictly banks are resolved, and use a large firm-level dataset to test its
effect. We find that a relatively stronger implementation of bank resolution rules has a statistically and
economically significant positive effect on firm growth – particularly with respect to firms that are structurally more dependent on bank financing. Our findings are robust to various specifications. Investigating
the transmission channels of this ‘catharsis effect’ reveals that it essentially works by means of benefiting
higher quality firms (quality channel) and reallocating credit to firms that need it most (quantity channel).
Additional analysis suggests that the ‘catharsis effect’ works best in banking systems that offer access to
international financing because such access mitigates the potentially negative credit supply effects of
liquidating insolvent banks. Taken together, our findings indicate that more attention should be focused
on developing incentive-compatible bank resolution regimes.
© 2014 Elsevier B.V. All rights reserved.
1. Introduction
In this paper, we test how strict and rules-based resolution of
insolvent banks affects the real economy. Although the theoretical
and empirical literature shows that financial intermediation generally has positive effects on the real economy, misled incentives
for banks, their creditors, and regulators in connection with bank
insolvency may distort banks’ credit allocation and monitoring
decisions. This may lead to suboptimal real economic performance.
A strict and rules-based resolution of insolvent banks, however,
might restore incentives in credit allocation and monitoring, which
would result in positive effects for the real economy. Such a
mechanism would be a manifestation of Schumpeter’s concept of
creative destruction in the financial sector: Insolvency and resolution regimes promote the efficient reallocation of resources and
have a cleansing effect on financial intermediation. Therefore, we
argue that insolvency and resolution can be thought of as a form
of ‘catharsis’ in the banking system that cleans out moral hazard
problems and distorted incentives.
∗ Correspondence to: Department of Economics and Business Administration, Goethe University Frankfurt, Grueneburgplatz 1, 60323 Frankfurt am Main,
Germany. Tel.: +49 69 79833733.
E-mail address: josef.korte@finance.uni-frankfurt.de
http://dx.doi.org/10.1016/j.jfs.2014.05.003
1572-3089/© 2014 Elsevier B.V. All rights reserved.
Based on this rationale, we hypothesize that strict and rulesbased regulatory insolvency leads to a ‘catharsis effect’: When
insolvent banks that warrant legal closure in accordance with a
prompt resolution rule are led into strict insolvency resolution,
incentives in credit allocation are restored, which increases real
economic performance. However, the strength and direction of
the effect are a priori not obvious because positive real effects of
restored incentives might be outweighed by negative credit supply
effects of individual bank closures. Moreover, the effect is likely to
vary across different types of firms and across different financial
systems.
Thus, we subject our hypotheses to empirical testing and investigate whether such ‘catharsis’ in the banking system has an effect
on the real economy and what the mechanisms and conditions
of its operation are. We propose a new indicator to measure the
strength of ‘catharsis’, i.e., how strictly insolvent banks are resolved,
and use a firm-level dataset with more than 2 million firm-year
observations to test its effect on firm growth. However, research
into the real economic implications of the financial system is frequently subject to concerns about causality and endogeneity. We
attempt to overcome these concerns and to establish causality with
a three-step identification strategy. We begin with a regression
model that exploits the panel characteristics of our dataset, employ
an instrumental variable setup, and finally utilize an interaction
approach, which presumes that firms that are more dependent on
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J. Korte / Journal of Financial Stability 16 (2015) 213–231
bank financing will experience stronger growth when the resolution regime for insolvent banks is stronger compared with firms
that depend less on bank financing.
We find that a relatively stronger implementation of bank resolution rules has a statistically and economically significant positive
effect on firm growth – particularly for firms that are structurally
more dependent on bank financing. Our findings are robust to various specifications. An investigation of the transmission channels
of the ‘catharsis effect’ reveals that it essentially works by means
of benefiting higher quality firms and reallocating credit to firms
that need it most. Additional analysis suggests that the ‘catharsis
effect’ works best in banking systems that offer access to international financing because such access mitigates the negative credit
supply effects of liquidating insolvent banks.
This paper contributes to the empirical literature at the intersection of three areas of research. First, it augments previous research
on the real effects of the structure and conduct of financial intermediation. Significant contributions have thus far evaluated the
economic effects of foreign bank entry and financial integration
(Giannetti and Ongena, 2009), bank competition (Cetorelli and
Strahan, 2006; Cetorelli, 2004), deregulation (Bertrand et al., 2007),
bank efficiency (Hasan et al., 2009), and systemic banking crises
(Dell’Ariccia et al., 2008; Kroszner et al., 2007; Rancière et al., 2008).
To the best of our knowledge, the effects of bank insolvency and
resolution regimes on real economic performance have not been
empirically evaluated thus far. Second, this paper contributes to the
literature on alternative treatments of failing banks. Whereas the
effects of various accommodating policies have attracted a significant amount of attention (Black and Hazelwood, 2013; Claessens
et al., 2005; Dam and Koetter, 2012; Giannetti and Simonov, 2013;
Honohan and Klingebiel, 2003; Laeven and Valencia, 2013), there
remains a lack of conclusive empirical evidence about the real
effects of cleansing resolution regimes. Third, this paper adds to
the literature that evaluates the implications of bank insolvency.
Previous research examines the effects of insolvency on bank
behavior (Caballero et al., 2008; Peek and Rosengren, 2005; Igan
and Tamirisa, 2008), regulatory behavior (Brown and Dinç, 2011;
Imai, 2009), and individual bank customers (Djankov et al., 2005).
We attempt to complement the empirical literature by testing for
the implications of rules-based bank insolvency regimes for firm
growth.
The remainder of this paper is organized as follows. Section 2
discusses the related literature from which our motivation and
hypotheses result. In Section 3, we introduce our model and identification strategy. The dataset, our proposal of a bank catharsis
indicator, and descriptive statistics are presented in Section 4. In
Section 5, the results of the analyses are presented along with analytical extensions on the transmission mechanisms and conditions
of operation of the ‘catharsis effect’. These are complemented with
several robustness tests in Section 6. Section 7 concludes.
2. Related literature and hypotheses
Banks generally contribute to the performance of the real economy by collecting, transforming, allocating, and monitoring credit
in its most productive uses, thereby improving the efficiency of
capital allocation and reducing the cost of external financing (Beck
et al., 2000; Levine, 2005). This link between financial intermediation and the real economy has been empirically established in the
literature (Fisman and Love, 2007; King and Levine, 1993; Rajan
and Zingales, 1998). However, there are sources of market failure in financial intermediation. For example, agency problems and
moral hazard distort incentives and lead to economically suboptimal outcomes that materialize in the misallocation of credit or
in the inherent fragility of the financial system. One area of particular concern is the treatment of distressed banks, particularly
with respect to the resolution of insolvent financial institutions.
The previous literature analyzes several dimensions in which the
treatment of failed banks can establish or distort incentives and
thereby influence the behavior of financial intermediaries, which
ultimately has an impact on the real economy:
• First, banks may exhibit distorted incentives arising from their
anticipated treatment in the case of insolvency. Because bank
failures are associated with strong negative externalities, individual banks may not need to fear bankruptcy but can anticipate a
bailout based on implicit or explicit government guarantees. This
can lead not only to intentional (excessive) risk-taking (Beltratti
and Stulz, 2012; Fortin et al., 2010) and the unsound inflating of balance sheets (Demirgüç-Kunt and Detragiache, 2005)
but also to insufficient screening and monitoring of borrowers
(Dell’Ariccia and Marquez, 2006) and incentives to create excessive complexity (DeYoung et al., 2013). Consequently, distorted
and suboptimal credit allocation and monitoring may result in
negative effects on the real economy.
• Second, in addition to individual bank behavior, Acharya and
Yorulmazer (2007) and Acharya (2009) model how the timeinconsistency of bank closure decisions can lead to incentives
for banks to herd into the same asset classes in an effort to be
‘too-many-to-fail’ – effectively creating systemic risk. Empirical
evidence supports their predictions by showing that governments are less likely to close or take over a bank if the entire
banking system is in crisis (Brown and Dinç, 2011; Kasa and
Spiegel, 2008) and that banks tend to herd in times of low capitalization (Stever and Wilcox, 2007). Such herding behavior distorts
the credit allocation and monitoring functions of financial intermediaries because it leads to a concentration on particular asset
classes that may not necessarily be merited by economic considerations.
• Third, incentive distortions that have detrimental effects on the
real economy can also arise when a bank is severely undercapitalized or about to fail. In such a situation, a financial intermediary
can be seen as an option to its owners that is more or less out
of the money and that can only create value through volatility.
Thus, the incentives grow to further substitute risk for economic
soundness in an effort to ‘gamble for resurrection’ (Freixas and
Rochet, 2008; Marinc and Vlahu, 2011). Distressed banks may
also discontinue effective credit monitoring and roll over nonperforming loans (Igan and Tamirisa, 2008; Peek and Rosengren,
2005; Rajan, 1994), which will eventually depress economic
growth (Caballero et al., 2008), or even engage in ‘looting’, i.e.,
channel funds to related firms (Akerlof and Romer, 1993; La Porta
et al., 2003). Leaving banks at low net worth could also harm
economic growth by raising the agency cost of finance and suppressing investment. Such effects are similar to those described
in Bernanke and Gertler’s Bernanke and Gertler (1990) concept
of financial fragility.
• Fourth, when banks’ lending decisions are prone to moral hazard, banks’ creditors might be considered a disciplining force.
However, little monitoring and disciplining are exerted by depositors that are typically small, dispersed, and properly insured
by a deposit insurance system (Demirgüç-Kunt et al., 2008;
Demirgüç-Kunt and Huizinga, 2004; Calomiris and Kahn, 1991;
Kaufman, 2006). The disciplining role of debtholders is also dubious when the expectation of (implicit) bailout guarantees gives
such debtholders little incentive to monitor the banks or to
adjust risk premiums accordingly (Acharya et al., 2013; Bliss and
Flannery, 2002; Gropp and Richards, 2001; Morgan and Stiroh,
1999). Creditors that share the rents from bank risk-taking may